What is escrow?
Escrow is a safe holding account managed by a neutral third party. Think of it as a referee holding the ball until both teams agree on the rules. You'll deal with escrow in two completely different ways as a homeowner. First, you use it when you buy a house to hold your deposit. Second, your mortgage lender uses an escrow account to save up for your property taxes and insurance bills. The word actually comes from the Old French word escroe. That meant a scrap of paper or a scroll. In medieval times, legal agreements were written on these scrolls and held by trusted third parties until conditions were met.
Escrow when buying a house
When you are buying a home, you usually write a check to show you are serious. This is called earnest money. You don't give this money directly to the seller. Instead, it goes into an escrow account. An escrow agent holds the money safe while you get your inspections and finalize your loan.
If the deal goes through, that money counts toward your down payment. If the seller backs out, you get your money back. The escrow company charges a fee for doing this work and handling all the final paperwork. This fee is usually split between the buyer and the seller. Escrow fees typically cost 1 to 2 percent of the home purchase price. For a 300,000 dollar home, your share might be 1,500 to 3,000 dollars, though ranges vary based on your location and the company you use.
Escrow for taxes and insurance
Once you own the house, your mortgage lender will likely set up a new escrow account for you. They want to make sure your property taxes and home insurance get paid on time. If you don't pay those bills, the house could be seized or destroyed with no safety net. The lender protects their investment by paying those bills for you.
Here's how the process works:
- The lender adds up your yearly tax and insurance bills.
- They divide that total by 12.
- They add that amount to your monthly mortgage payment.
- They hold that extra money in your escrow account.
- When the tax or insurance bills are due, the lender pays them from that account.
This means you don't have to scramble to save up thousands of dollars at the end of the year. Your lender handles it for you.
Escrow shortages and changes
Your monthly mortgage payment might change every year. This surprises many new homeowners. If you have a fixed loan, your actual mortgage payment stays the exact same. However, your property taxes and insurance premiums almost always go up over time. Because of this, your lender performs an escrow analysis once a year.
If your taxes went up, your escrow account won't have enough money to cover the new bill. This is called an escrow shortage. Your lender will pay the bill, but they will require you to pay them back. You usually have two choices. You can write one big check to cover the shortage, or you can let the lender spread the shortage over the next 12 months. If you spread it out, your monthly mortgage payment will go up to cover the shortage and the new higher tax rate.
Can you remove escrow?
Some homeowners prefer to manage their own bills instead of letting the lender do it. If you want to cancel your escrow account, you have to meet certain rules. Most lenders require you to have at least 20 percent equity in your home before they let you drop the escrow requirement. You also need a perfect record of paying your mortgage on time for at least a year.
If you cancel your escrow account, you take full responsibility for paying your own taxes and insurance. You must remember to set money aside every single month. If you forget and miss a tax payment, your local government will charge you steep penalties. They can even place a lien on your house. Managing your own property taxes and home finances gives you more control over your cash flow, but it requires serious discipline.
